In Part I of this three-part series, I defined some terms used in this article (click here).
By the end of this article, you’ll know how to tell if the products or services you’re selling are profitable or if you’re losing money on them. You can then take action on the troublemakers to increase your bottom line.
If you’re an owner or manager, this kind of analysis is critical to your success. If you suffer from arithmophobia (a real word meaning fear of numbers or arithmetic), don’t let it get the better of you and read on with me.
Now let’s do some analysis. Let’s assume this is our income statement in dollars and percentages of sales.
Immediately we can see we’re a $3,000,000 company (see Sales), our overhead is $1,440,000 (Total Operating Expenses) and we’re profitable (Net Income is $240,000). But just looking at dollars only gets you part of the way there. We must really memorize the percentages each row of the income statement represents to Sales.
We can see that of every dollar of Sales, 40 cents goes to expenses directly associated with purchasing and delivering our goods or services (i.e., Cost of Goods Sold = 40%). What’s left is Gross Profit, called gross because it’s before deducting Operating Expenses as opposed to Net Income, which is after deducting Operating Expenses.
Gross Profit must be enough to cover Operating Expenses and Other Expenses such as interest expense and still have some left over as profit. Gross Profit as a percentage of sales is the most CRITICAL income statement ratio for managing profitability and is called Gross Margin.
Here’s why it’s such an important ratio. It helps us determine if the products or services we’re selling are profitable enough on a gross basis to cover our overhead and desired profit.
If we source a new product that will give us gross margin of 40% knowing that our overhead is 48%, we should reject such product.
If we look at the gross margins of individual products or services that make up our product line, we’re likely to identify some that do not earn sufficient gross margins. These should be addressed immediately.
If our overhead has been streamlined as much as possible and can’t be reduced materially, then we can either increase the sales price, reduce our purchase cost, or discontinue the product.
Another important income statement ratio is net margin, which is Net Income as a percentage of Sales.
Let’s say we want to earn a net margin of 10% of sales next year. How much must our gross margin be to allow us to earn a 10% net margin? Working backwards using the percentages above, let’s calculate it.
This means that our Cost of Goods Sold can’t be more than 38% of the sales price to yield a gross margin of 62%.
Let’s say that our Cost of Goods Sold, which per above is currently at 40% of Sales, is composed of the following:
If we know that shipping costs us 10% of sales, and we need the total Cost of Goods Sold percentage to be 38% to make our gross margin of 62% and net margin of 10%, then our purchase cost of goods cannot exceed 28% of the sales price.
So if we have a product we can sell for $10, we can’t pay more than $2.80 for it (28% purchase cost). Otherwise, we’ll lose money on each sale and no amount of volume will make this product tolerable. The more we sell of a losing product, the more we lose.
Embedding our income statement percentages in our brains enables us to price our goods properly, negotiate prices with vendors and decide which products to keep or drop.
Thus far, the key takeaways from this series of articles on income statements is to know how your income and expense accounts are grouped in your income statement and the percentage each line in your income statement bears to sales (especially your gross and net margins).
Try to group your expenses into the cost of goods sold and operating expense subtotals consistent with your industry’s practice so you, your lenders and investors can compare your numbers to your industry averages.
If you have any questions about your income statement, reach out to me and I’ll go over it with you.